Sunday, December 16, 2007

Eugene Fama on MBS

He is interviewed here:

And he says:

Region: Some observers have suggested that regulators and others have put too much reliance on ratings agencies to determine the risk of mortgage-backed securities and that even financially sophisticated parties “didn’t really know what they were buying.” Is this evidence that credit markets are inefficient?

Fama: That story just doesn’t appeal to me. First of all, it’s well known that rating agencies tend to lag actual changes in credit worthiness. For example, stock prices predict changes in ratings better. The best models of credit quality are basically options pricing models that work off the stock price. So I’m very skeptical of these stories. The bond market is a simpler market than the stock market. Bonds are simpler to evaluate than stocks, because there’s downside risk, but you don’t have to worry much about the upside: They’re not going to pay you more than they promised. So bonds are much simpler to deal with. Now bond products have become more complicated because of the securitization of that market, but still not that big a deal.

I disagree on a couple of counts. First, the fact that investors are not sure what to make of AAA right now is one of the causes of our current problems. When I gave my talk at USC the other day, Larry Harris asked whether some of the AAA MBS was safe. The answer, of course, is that some of the AAA stuff is very safe. When an MBS gets the first 35 percent of promised cash flows from the underlying mortgages, it is, indeed, very safe, and yet it is trading at a substantial discount, because investors (and likely overseas investors in particular) do not know what to make of AAA right now.

Second, Mortgage Backed Securities are very tricky investments, because borrowers get control of two embedded options: a call option to prepay the mortgage when interest rates go down, and a put option to default on the mortgage when house prices fall. So far as I know, no one has yet to do a good job pricing these options acurately, because borrower behavior with respect to the puts and calls has been, shall we say, unstable.

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